The Sun Really Is Rising In Japan

Tokyo’s stockmarket appears to have begun a long-term upswing, and promised government reforms can only mean good news. By Shane Oliver

After a long night and many false dawns during the 1990s, the sun finally does appear to be rising in Japan. A year ago there was much concern that the recovery in the Japanese economy and stockmarket would prove to be just another false dawn, like those of the 1990s.

But Japan has defied these fears. Despite a rough patch, economic recovery has remained on track and the stockmarket has broken out to new four-year highs. Our assessment is that the malaise, which engulfed Japan in the 1990s, is receding, and that Japan is in a durable recovery.

The re-election of Prime Minister Koizumi with a clear mandate for economic reform only adds to our confidence. However, while we see the Japanese stockmarket as having entered a longer-term upswing, average returns over the next five to 10 years are likely to be constrained.

MORE THAN JUST A CYCLICAL BOUNCE

After Japanese shares peaked in 1989 (at just below 39,000 on the Nikkei 225 index), and its economy went through the rolling recessions of the 1990s, there were three occasions where the stockmarket rebounded strongly, only to slump to new lows (with the Nikkei hitting 7604 in 2003). Each of these was associated with brief economic recoveries that quickly faded.

The latest share market rebound and economic recovery looks far more sustainable though:

• First, the corporate sector has finally recovered from the imbalances that were left in the wake of the bubble years of the late 1980s. Japanese companies are now in better shape than at any time over the past 15 years: debt to equity ratios have been halved; business failures have fallen sharply; the banks’ non-performing loans have been reduced; excess capacity has been removed; and profit margins are above earlier highs. Additionally, business confidence is up sharply.

• Reflecting the improvement in the corporate sector, business investment has been picking up and is likely to continue to do so.

• Similarly, the improvement in the corporate sector has meant that companies are employing again. For the first time since the 1980s, the unemployment rate has been falling steadily over the past two years. This, along with improved consumer confidence and stabilising house prices, is contributing to an improving trend in consumer spending.

• The rebound in private sector spending has meant that this recovery has been far more sustainable. It has been less dependent on wasteful public spending (unlike in the 1990s) and stronger exports (and hence growth in the US and China).

• Deflationary pressures appear to be abating, which is good news to the extent that falling prices only encourage consumers to delay spending. The rate of decline in consumer prices has slowed and real estate prices have started to rise.
• Finally, the recent landslide election victory of Prime Minister Koizumi '” in an election triggered by the Japanese Diet’s (or Parliament's) rejection of Koizumi’s postal system reform bills '” has provided him with a mandate for further economic reform.

In Japan a large proportion of savings is done via the public sector postal savings system and reforming it is seen as a key step in reforming the economy. Following the election, the Government’s postal reform bill will now pass. It is likely to be followed by reform of: the health-care system; the pension system; the public service; public financial institutions; and greater outsourcing of functions to the private sector.

Koizumi has indicated that “what can be done in the private sector, should be done in the private sector”. An acceleration in economic reform should be positive for long-term economic growth in Japan.

These considerations suggest that although there will be occasional bumps in the road (like during mid last year) the recovery in Japanese economic growth that began in 2002 is not just another dead cat bounce but will prove to be sustainable. This should underpin further gains in the Japanese stock market and confirm that the long-term downtrend in Japanese shares from the late 1980s peak is well and truly over.

After a period of consolidation during the last 16 months, the Japanese stockmarket has since broken out to new four year highs on the back of recent positive economic and political news. This should encourage further buying from a technical perspective.

The trend is now up, but medium term returns from Japanese shares are still likely to be constrained. Although economic and political considerations augur well for the Japanese stockmarket, our assessment remains that returns from Japanese shares will be constrained over the medium term (the next five to 10 years).

• Firstly, thanks to a low birth rate and no real immigration, the Japanese population is now falling and is rapidly aging. Within 100 years Australia will have a bigger population than Japan! With the labour force starting to stagnate, future economic growth must come from productivity improvements.

• While there is significant potential to boost productivity growth – and the mandate for reform provided to the Koizumi Government will help immensely '” the domestic economy in highly inefficient due to a lack of competition and it is doubtful this will change quickly.
• Finally, the need to get the Japanese budget deficit and public sector debt '” now among the worst in the OECD '” under control will mean cutbacks in Government spending or tax increases, which will have a slight dampening impact on economic growth.

These considerations suggest potential (and long-term) real economic growth in Japan may be just 2% pa (at best). While “mean reversion” would suggest Japanese shares should start to outperform global shares on a sustained basis, after a decade of underperformance, this is hard to see on the basis of economic fundamentals alone.

Over the medium term a good way to project likely equity returns is to add current dividend yields together with likely long-term nominal GDP growth. This of course assumes that earnings and dividends grow in line with nominal GDP growth and there are no changes in valuations (ie, share prices rise in line with earnings which in turn grow in line with nominal GDP). Our medium term return projections are shown below for major stockmarkets.

For Japan we have assumed a return to inflation of around 2% pa and real economic growth of 2% pa, giving nominal GDP growth of 4% pa. So while the worst may be over for the Japanese share market, it is still hard to see it outperforming global markets on a medium term basis, especially given its relatively low long-term economic growth potential and low starting point dividend yield.

Asian (ex-Japan) equity markets, with their higher starting point dividend yields and stronger structural growth prospects should provide a better medium term bet.

CONCLUSION

Japan’s economic recovery is sustainable and not just another 'dead cat bounce’ like those of the 1990s. The mandate for economic reform provided to Prime Minister Koizumi provides further confidence in Japan’s improving outlook. It also suggests that Japanese shares have further gains ahead of them and are now in the early stages of a secular bull market, after the long bear phase from 1989 to 2003. However, structural constraints suggest Japanese shares may remain relative under performers over the next five to 10 years.

The improving Japanese economic outlook is good news for the Australian economy, particularly the resource sector, with Japan still our largest export destination.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591) (AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.